Most investors put nearly all of their wealth into bonds and stocks. Coming from a family of entrepreneurs and private equity investors, I never really understand the appeal of this approach.
Bonds are easy to rule out because they pay literally nothing and do not protect against the inflation. At most, they provide diversification benefits, but this diversification comes at a steep cost and it's mostly unnecessary for long-term oriented investors.
On the other, stocks are a bit trickier. Theoretically, they have generated good returns over long time periods. However, this is very theoretical. Most individual investors never benefited from these good returns because the extreme volatility and the lack of income ultimately causes you to lose patience. Very few are the investors who held on to the same stocks for decades without ever trading in and out.
Moreover, when you invest in stocks, you are supposed to understand in what you invest. But let’s be real for a second. This may sound a bit provocative, but unless you are a businessman, you probably know very little about business. Running a small business and understanding all its complexities is extremely difficult and unpredictable. Most who try end up failing at it.
You are required to make very complex and uncertain assumptions without even being deeply involved with the company. Professional analysts cannot do it accurately, and you are probably investing on a part-time basis as a hobby.
I was never able to understand these stocks, but I recognized this limitation. Most people are grossly overestimating their skills as an investor. They think that they can pick the winners and beat the market.
In reality, 99% of active stock investors underperform passive ETFs and index funds. A study by JPMorgan found that the average investor earned just 2.6% annual returns during the past 20 years:
So I think it's fair to say that stocks are poor investments for the great majority of investors. They may generate little income, they are very volatile, and ultimately they give you a sense of speculation which causes you to lose patience and panic.
Stocks and bonds are out. They are poor investments for most people.
What does this leave us with?
I always have seen much more appeal in investing in real estate. It pays high and steady income, it protects against inflation, it appreciates over time and it's very simple to understand.
You have a tenant who pays rent. The value of the property appreciates as a result of increasing demand, despite limited supply (they are not making more land in attractive locations). And you can finance a good portion of it with a cheap mortgage to realistically reach 12%-15% annual returns.
Buy at a 6-7% cap rate
Finance half at a 3% rate
Appreciate by 2-3% per year
= 12-15% annual returns
Most importantly, real estate investors really earned these returns because unlike stock investors, real estate investors are unlikely to panic and sell at the worst time. Real estate pays a lot of income which helps you to remain patient.
Over long time periods, real estate has generated higher (unlevered) rates of returns than stocks and bonds, despite paying more income and being less risky:
Real estate is the world’s largest asset class, and yet, most investors barely invest in it outside of their primary residence. They favor traditional stocks and bonds over apartment communities, office buildings, retail centers, hotels, timberland, and other real estate investments.
I do the opposite. And this is what makes my approach to investing very unique.
I personally invest more than 50% of my net worth into real estate. And despite having a private equity real estate background, I invest mostly in publicly traded REITs.
Now, I already know that many of you will say:
But… REITs are stocks, right?
And the short answer is yes. Technically speaking, REITs are structured as corporations, and you invest in them by buying stock in the company.
However, practically speaking, REITs are real estate investments and very different from traditional stocks. Most importantly, REITs pay no corporate income tax, they must distribute 90% of their income in dividends, and they can invest in real estate only.
Private investors will often own real estate through a Limited Partnership, an LLC, or a Corporation. It does not make it a “stock investment,” it remains real estate. In fact, the returns of REITs and real estate are near-perfectly co-integrated around the same factors according to studies from Cohen & Steers (CNS). Not a big surprise when you consider that REITs own nothing else than real estate.
Why Invest so Much in REITs?
We believe that REITs are the pound for pound best investments that you can make. The combine the positive attributes of real estate:
- High income
- High total returns
- Inflation Protection
With all the positive attributes of stocks:
- Low transaction cost
- Diversification and easy capital scalability
You essentially combine the pros together and remove most of the cons of both asset classes. And this is why I prefer REITs over private equity real estate investments.
You save the ~5-10% closing cost, you have daily liquidity, diversification, easy capital scalability, and professional management. You earn the returns of real estate without all its risks and downsides.
In fact, REITs have actually produced even higher returns than private real estate. This is surprising to many, but hear me out:
- REITs enjoy enormous economies of scale.
- REITs have access to better financing terms.
- REITs have access to public equity markets.
This last point is especially important because it allows REITs to regularly issue new equity, reinvest it at a positive spread, and grow cash flow at a faster rate than what would be achievable for private investors. REITs commonly grow cash flow at 5% per year. In comparison, private real estate investors are happy if they can grow cash flow at 2% per year.
As a result, REITs outperform private real estate by ~4% per year according to a study produced by Cambridge. Over the past 20 years, REITs generated 14% annual total returns on average – even despite hitting the great financial crisis in between:
However, this does not mean that every REIT is worth buying. Just like for stocks, most REITs are fairly valued, some are overvalued, and only a few are undervalued.
As an example, Realty Income (O), a sector-favorite, trades at 22x FFO and a 3.7% dividend yield. It might be a better value than regular stocks, but it's not particularly appealing either.
Below we present some attractive REIT investments across two of my favorite REIT sub-sectors: Net Lease REITs and Foreign REITs.
Net Lease REITs: As Steady As It Gets
Net Lease REITs are the safest and most predictable of all REITs. This is because they lease properties with exceptionally long lease terms of 10-15 years, automatic rent increases, and no landlord responsibilities. Generally, the tenant must even pay for property taxes and maintenance.
Most net lease REITs have more than 10 years left on their leases, and therefore, even if we went into a recession tomorrow, they would keep earning steady cash flow to fund sustainable dividends.
The sweet point here is to find a net lease REIT that yields >5% and has >5% annual growth. Combined together, this results in >10% annual total returns without any valuation expansion.
Earning double-digit returns from a recession-resistant investment is very attractive so late into the cycle. And for this reason, we heavily overweight them in our Core Portfolio.
Right now, most net lease REITs are overpriced and fail to meet the income and growth requirements that we listed above. However, a few underpriced companies remain.
A great example that we have been buying lately is Spirit Realty Capital (SRC).
SRC is very similar to Realty Income (O). They both own a service-oriented net lease properties with a lot of fast service restaurants, fitness centers, gas stations, and grocery stores. Dollar General (DG) property owned by SRC:
SRC has more than 10 years left on its leases and very reliable cash flow, just like Realty Income. However, the main difference is the valuation.
SRC pays a 6.5% dividend yield and has guided for 6.5% AFFO per share growth in 2020. This results in a 13% total return.
But there's more. We estimate that SRC is undervalued by at least 20% relative to peers. Assuming that it takes three years for the mispricing to correct itself, SRC shareholders would be set to earn ~15-20% annual total returns from a defensive REIT.
In today’s volatile market, this is a great opportunity that we are buying.
Another attractive opportunity is EPR Properties (EPR). EPR is different from other net lease REITs in that it focuses on nichier net lease properties such as movie theaters, golf complexes, ski areas, and other. AMC (AMC) property owned by EPR:
The market is not sure how to value these assets. Most investors perceive them as riskier properties. In reality, EPR enjoys some of the most resilient portfolio metrics of all REITs with occupancy rates never dropping below 97%.
Right now, EPR enjoys 13-year leases and 1.8x rent coverage on average. This rent coverage is resilient and consistent year after year. Therefore, its cash flow is actually among the most predictable of all REITs.
EPR pays an ~12% dividend yield, which it just hiked, and enjoys a ~5% normalized growth rate. Combined together, this result in a 17% annual total return, but just like SRC, we believe that EPR is set for material FFO multiple expansion in the coming years. EPR is priced at 10x FFO, while some of its casino net lease REIT peers trade at 16x FFO. We believe that it's EPR that should trade at a premium valuation given its long history of outperformance and better portfolio diversification. As the multiple expands closer to 15x FFO, shareholders are set for ~20% annual returns – from a highly-predictable net lease REIT.
Foreign REITs: Many Overlooked Opportunities
About 25% of my real estate investments are abroad. This allows me to diversify my real estate portfolio, reduce its risk, and boost its yield.
Most REIT investors never look abroad for opportunities because of the perceived difficulties of investing in a foreign market. In reality, this is just as easy as investing in US REITs.
You need to request trading permissions from your broker. Then you need to convert your currency into the foreign currency. Finally, you write down the correct ticker and you buy shares. There's also a big misconception when it comes to taxes. A lot of investors refuse to invest abroad because of withholding taxes. What they ignore is that most countries have treaties to avoid double taxation. Therefore, you can use this withholding tax as a “tax credit” in your home country to avoid being taxed again. I recommend discussing with a tax expert, but this really isn’t difficult.
It's especially unfortunate that investors skip foreign REITs because the best opportunities are often in overlooked, international markets.
Today, more than 30 countries have adopted a REIT regime:
At High Yield Landlord, we invest heavily in Europe and Asia, but have stayed away from Africa and the Middle East. We have found that a lot of Foreign REITs are poorly managed with flagrant conflicts of interest. As an example, in Asia it's common for REIT sponsors to develop properties with a separate entity and then have the REIT buy these properties at expensive prices. This is not an arm-length transaction and US REIT investors would not tolerate it. However, in Asia, they still get away with it.
And so the most important investment criteria in international REIT markets is the management and its alignment of interest. By removing the REITs that are poorly managed, you can immediately skip more than half of the REITs.
In Asia, there are two sponsors that have very good reputations. These are CapitaLand (OTCPK:CLLDF) and Mapletree. They manage a lot of REIT entities and most of them are richly valued.
However, a few exceptions remain. As an example, Mapletree North Asia (Traded in Singapore with ticker SGX:RW0U) is currently trading at a 52-week low. It owns properties in Hong Kong, China and Japan. It performed very well since its IPO up until the riots erupted in Hong Kong. The sentiment of the stock took a hit. And this was immediately followed up by the Coronavirus crisis. As a result Mapletree’s North Asia flagship vehicle is now trading at a 6.5% dividend yield (generally closer to 4% yield) and positioned for strong upside once a solution is found for the coronavirus.
Gateway Plaza, Beijing – Property owned by Mapletree North Asia:
In Europe, we like the richer central and northern European countries. Germany, Finland and Sweden present good opportunities right now. The UK REIT market also is cheap and we believe that the market is overreacting to Brexit. As an example, British Land (OTCPK:BTLCY), a local blue chip with a London-heavy portfolio of trophy properties, is currently priced at a 50% discount to NAV and pays a 6% dividend yield. It enjoys a fortress balance sheet and is buying back its shares to create long term value.
Putting it All Together
Currently, we invest in 30 out of ~300 REIT opportunities(including International markets). These investments represent about half of my net worth. By being very selective and only investing in the REITs that we believe to be undervalued, we are able to earn high income, with good margin of safety, and long-term appreciation potential:
- They pay 8% dividend yield on average.
- They enjoy a safe 69% payout ratio on average.
- They trade at just 8.6x cash flow.
- And they generate steady growth.
It is the combination of yield, value, growth and safety that sets our strategy apart from other stock investors. You cannot get this level of income and safety from regular stocks. At least, we have not figured out how you would do it.
Investors are slowly awakening to this reality. Still 20 years ago, investors would barely invest in real estate. Today, real estate represents roughly one-quarter of institution’s portfolios. And by 2030, the allocation to real estate is expected to reach up to 40%:
With this mind, are we wrong to allocate so much in real estate? Or are we just ahead of the curve? Share your thoughts in the comment section! As always, thank you for reading!
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